First Eagle's Matthew McLennan On The Recent Market TurmoilVW Staff
First Eagle’s Matthew McLennan On The Recent Market Turmoil
After a period of very low volatility and gradually rising risk-asset prices, the past week witnessed a somewhat dramatic rout in equity markets. We believe this was not a crisis, but a genuine correction. The stock market rout around the world this past week has largely been attributed to weakness in Chinese equities. We have been speaking about the imbalances in China for some time, and a correction of speculative excesses in that market is a healthy development. We feel that the Chinese have had their fingers in the dike in a few places, be it their attempts to prop up the stock market, their willingness to let their currency start to depreciate after a long period of appreciation, or their recent decisions to cut interest rates and inject liquidity into the economy.
As in the West, authorities in China are discovering that debt is far easier to create than it is to moderate or eliminate. We expect the short-term to medium-term road ahead for China to continue to be complicated. Investment levels have not yet fallen to global norms for high-growth economies, local government debts have not been meaningfully restructured, the impact of factory automation on labor markets is in its early days, social problems with public health and pollution need to be addressed, and the future geopolitical strategy remains unclear. The Xi administration has been committed to genuine reforms, but these are unpopular with entrenched interest groups, and the move to reform will be politically complicated as asset markets adjust to the last generation’s epic credit boom.
However, the stock market rout in the developed world is about more than China. Yes, the price of risk is a global commodity and increased risk aversion in China did play a role in the downturn, but we have our own issues to digest. We have spoken repeatedly about the fact that the West currently has more debt (household, corporate and sovereign) than before the last crisis. Plunging longterm interest rates and commodity prices signal that in a world with too much debt, nominal growth is likely to be low. Furthermore, with margins generally very high and the price of labor starting to rise, the combined specter of sluggish top-line growth and margin moderation doesn’t portend well for profits.
Getting rid of excess debt is tricky for Western economies, too. Easy fiscal policy and quantitative easing enabled some element of private-sector restructuring and deleveraging, but it was more than offset by growth in government debt. If we stopped issuing new debt and didn’t restructure any existing debt, the rate of debt adjustment would be limited to the rate of productivity growth in the economy. This would imply a generationally long adjustment. And, of course, we haven’t stopped issuing debt. As a result, we’ve resorted to repressing interest rates relative to money supply growth.
In order to deleverage, economies that are overweight manufacturing (and therefore subject to the pressures of automation) and economies that culturally don’t like to restructure debt are generally forced to try to depreciate their currencies and run current account surpluses. Unfortunately, the resultant dollar strength means that the U.S. will generally run a larger current-account deficit, which will make deleveraging more difficult. The last few generations experienced mid- to high-single-digit nominal growth during a long-term global leveraging cycle. If we have to pay the piper and deleverage, the next generation may experience low-single-digit to mid-single-digit nominal growth. As the Austrian economist Ludwig von Mises reminded us in his classic book Human Action, real wealth cannot be created by “little scraps of paper.” The sovereign bond and commodity markets may already have absorbed this new, more challenging reality, but arguably the equity market and credit spreads have not.
Investing is all about spotting the gap between price and prospects. If nominal growth prospects are sluggish, how can we feel comfortable with equity prices that are high by historical standards? We have been speaking for some time about the complacency embodied in the prices of risk assets. The U.S. equity market was trading at over 20x trailing peak earnings, but historical norms are in the 12-18x range.1 Investors had generally bid up price/earnings ratios as earnings were deemed attractive relative to repressed interest rates. While this was true, perhaps investors ignored the fact that interest rates are low because there’s too much debt, and at some point in the future, the correction of that excessive debt may put future earnings power at risk. We also have talked at length about the narrowing of the market, which has historically been a key negative technical. We talked about the fact that what had momentum lacked value and what had value lacked momentum. We talked about why gold still makes sense to us as a potential hedge. We believe this correction has not brought the market to bargain levels: We are simply back to the high end of the historical orbit (18x trailing peak earnings, with an earnings peak that is elevated due to high margins).
One other point of interest is that gold, the euro and the yen appreciated during this downturn—the dollar was not the safe haven people may have expected it to be. Perhaps this reflects the sense that the dollar’s valuation had become stretched due to expectations that the U.S. alone would have a strong economy and higher interest rates. Whether or not the Fed raises rates has now come into question. The fall in oil and other commodity prices has arguably helped the Japanese and European economies at least as much as the United States.
Gold rose from its recent levels during the rout. Gold mining stocks generally did not keep pace, but we’ve always said that these shares have both an equity component and a potential hedging component. The equity factor tends to dominate in the short term and the potential hedging in the longer term.
First Eagle’s Matthew McLennan: Our Portfolios
We were a net buyer in the heat of the past few days. We saw some decent opportunities in some of the more extreme trading that occurred, and we focused our buying on what we believe are resilient companies with strong market positions and disciplined management teams. But there has not been enough distress for us to buy more mundane businesses that would be more vulnerable to a receding economic tide.
In the energy sector, we’ve clearly seen a pullback in the value of some upstream producers, but we’ve also seen the forward curve for energy prices continue to decline. We have continued to add to some of our positions in specialty services and energy-related industrials, which have been hit hard and which we think have a more attractive long-term business opportunity than the pure upstream energy producers.
During the past year, we’ve been net sellers in Japan. As we look across our portfolio of Japanese equities, prices have come back to levels where we feel more comfortable at this point. If we see further declines from this level, we could become a net buyer of selective equities in Japan.
Some of the higher-quality consumer names that have exposure to emerging markets have been hit hard, and we’ve been able to access them. Risk aversion has risen in the emerging markets, and not just in China. The Brazilian currency has lost half its value, and the market there has been weak. In the emerging markets, when you look for gaps between prices and prospects, you have to acknowledge that politics play a big role on the prospect side of the ledger. Politics have become more complicated in Brazil, Turkey, South Africa and Russia. We’d also be more enthusiastic about emerging markets if we’d seen a meaningful adjustment in their banks’ non-performing loan provisioning and related capital raising, but perhaps that all lies ahead.
Over the past month, our portfolios have declined in absolute terms by just over five percent. While we’re not happy with that outcome, our only solace is that the broader equity markets are down by around nine percent.3 Today, our portfolio feels more comfortably valued than it has for quite some time. Our crystal ball won’t tell us what happens next, but you can expect us to buy on weakness and trim on strength. Volatility is our friend, not our enemy, and if this market rout turns into a deeper crisis, we have plenty of liquidity to take advantage of it.
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